Cost Classification

Direct Costs and Indirect Costs

Direct costs

Costs that can be directly attributed to a specific product, service, project, or activity.
These are typically associated with resources directly used in production,
Eg: direct labor, direct materials, and the cost of operating production equipment.

Indirect costs

also known as overhead costs,
cannot be easily traced to a specific product or activity.
They support the overall operations and include expenses like utilities, management, administration, taxes, and quality control.
often allocated using a rational basis.
The sum of direct and indirect costs is often called the cost of goods sold or factory cost.

Fixed Costs and Variable Costs

Fixed costs

remain relatively constant regardless of production or activity levels, at least within a certain relevant range.
They are associated with maintaining basic operating capacity and do not change with output.
Examples include building rents, insurance, depreciation of buildings, equipment capital recovery, and minimum labor levels.

Variable costs

change in direct proportion to the level of activity or production.
As production volume increases, variable costs also increase.
Direct labor, materials, marketing, advertising, and warranty costs are often variable costs.
The difference between the unit sales price and the unit variable cost is known as the unit contribution margin.

Mixed Costs

also called semi-variable costs
have both fixed and variable components.
These costs have a base level that is constant, along with a portion that varies with activity.
Example: depreciation of an automobile, which has a fixed depreciation component due to time and a variable component due to usage, cost of electricity.

Marginal Costs

cost of producing one additional unit of a product or service.
represents the extra expense incurred when output is increased by one unit.
For example, if the cost of producing 20 units is $10,000 and the cost of producing 21 units is $10,045, then the marginal cost of producing the 21st unit is $45. An example of almost zero marginal cost would be adding one passenger in a public bus since adding one more passenger almost causes no additional costs to be incurred. That is why owners and drivers tend to put more and more passengers as there is little or no marginal cost associated.
Marginal cost is primarily affected by variable costs and not by fixed costs.

Sunk Costs

Those that have already been incurred and cannot be recovered, regardless of future decisions. They are not relevant in making future economic decisions.

First costs

They are also called initial costs, are associated with the initial investment in a project or asset.
This includes the purchase price, delivery charges, installation, initial training, and other costs required to start the project.

Annual operating costs (AOC)

ongoing costs incurred to maintain and support an asset or project. These include direct labor for operations, materials, maintenance, repairs, and other recurring expenses.

Capital costs,

Operating costs

recurring expenses associated with using an asset.
Capital costs are often converted to an annual equivalent through capital recovery, to compare them to recurring costs.

Product Costs vs. Period Costs

For financial statements, product costs are associated with the production of goods and are not expensed until the goods are sold. These costs are part of the cost of goods sold and include direct materials, direct labor, and manufacturing overhead.
Period costs are matched against specific periods of time and are expensed immediately. These include all selling and administrative expenses.

Manufacturing Costs

Manufacturing costs are those incurred in converting raw materials into finished goods.
They are divided into direct materials, direct labor, and manufacturing overhead.
Direct materials are the costs of materials directly used to produce the product.
Direct labor is the cost of labor directly involved in production.
Manufacturing overhead includes all other costs, like indirect materials, indirect labor, maintenance, utilities, and depreciation.

Non-Manufacturing Costs

Non-manufacturing costs include operating, marketing, and administrative costs.
Operating costs support daily operations, such as warehouse leasing.
Marketing costs relate to securing customer orders, including advertising and sales commissions.
Administrative costs cover executive, organizational, and clerical expenses for general management.